Investment
Bill
Gross Outlook
Clueless
Election season sometimes brings out
the worst in us or perhaps the worst of
us, depending upon your point of view.
Whichever perspective you take, the
current California recall has reminded me
that politics and Bill Gross just don’t seem
to mix. It is, of course, flattering to walk
down the street or be exercising in the
gym and be asked by total strangers why
I didn’t run for governor. But give-ups in
compensation and prestige aside, I excuse
their exuberance if only because they
couldn’t possibly be aware of my abysmal
failings in the political arena. The phrase
“he couldn’t be elected dogcatcher” was
meant for me, and my life history gives
testimony to it. I, for instance, made the
perfunctory run for vice president of my
high school junior year class in order to
stuff my resume with the requisite amount
of goodies to get into a good college.
My opponent was a savvy kid named
Mike Erickson who plastered “Elect ME
for Vice President” all over the school’s
walls, the ME being an abbreviation of
his name and a clever way to condense a
campaign slogan. Unfortunately I didn’t
get it, I was Clueless, but I thought it
October 2003
would be a good counter to print posters
importuning the juniors to “Elect ME for
Vice President – Bill Gross.” Somehow
that semi-plagiarized catch phrase failed
to excite the electorate and I went down
to a crushing defeat. Then there was the
time in my college fraternity when I threw
my hat into the ring for election to what
was as low a position as that proverbial
dogcatcher. Half the fraternity (or more)
hated my guts so I decided to woo them
by placing my name in nomination for
the Sheraton Hotel representative – being
responsible for reservations for parents
during homecoming and such. Even
though no one else was running, I was
somehow rejected on the basis of too
closely resembling “Animal House’s” John
Belushi. So it is on this brief yet more than
conclusive historical resume that I chose
to decline my supporters’ urgent plea to
run for governor of California. As you can
see, I pose no threat to the Terminator, or
anyone else in the state for that matter. All
of them could beat me, every single one,
even illegal immigrants I suppose, once
they get their drivers’ licenses.
 Investment Outlook
Actually I was elected to something
– Chief Investment Officer of PIMCO –
although I squeaked by in the early years
because no one else wanted the job, and by
acclamation in the later years. Sometimes,
though, I sense that my partners’ silence
if given vent would scream, “Elect ME for
CIO!” Thank goodness there’s nobody here
by the name of Mike Erickson. But being
the duly elected CIO, at least for now, I feel
it incumbent as the incumbent to speak out
on issues of the day, sometimes a tad afield
from the bond market, but mostly confined
to that arena. I wouldn’t want to jeopardize
my possibilities for political office by
opining too often on delicate topics such as
GE, IRAQ, or life itself. Some people might
not like me, turn their thumbs from up
to down, and not bend their chads in my
direction. Every vote counts as the Florida
election dramatically pointed out.
But sarcasm aside, I will continue to
opine. Last month and in other Outlooks,
I wrote about hegemonic decay – “What
We Worry?” – and tried to make the case
that our domestic economy was vulnerable
on several fronts. If and when domestic
interest rates – short-term, intermediate,
and/or long began to go up, then the
housing market as well as almost all of
our financed-based service and industrial
corporations would be affected. In
addition, I elaborated on the
���� �������������� ���� �� � �� ���������� ������
potential Chinese water torture ����
in which Asian holders of U.S.
Treasuries might trigger such
an interest rate increase and ����
therefore economic stagnation,
as their holdings became larger ����
and larger and therefore riskier
and riskier. Let me elaborate
����
on why our domestic and
therefore the global economy is
particularly vulnerable to a rise ����
in interest rates at this juncture ����
– no matter what the trigger. ������� ������ � ��������� ���� ���������
��� ���������� ��������� ��� ����
October 2003
During business cycles past, economic
recoveries continued for quarters and in
some cases many years beyond the initial
jump in yields whether it was Fed or
market induced – or both. Higher interest
expenses were absorbed as companies
regained pricing power. Demand increased
as unemployment came down and
hundreds of thousands of workers found
jobs every month. Today the recovery is
structurally different. Global competitors
– China, India, Brazil, and a host of others
– limit pricing-power by ferocious trade
policies whether they be currency based
or cheap labor oriented. At the same time,
their competitive exports are responsible
for a structural roadblock in employment
policies. U.S. companies hire more people,
they just don’t happen to live in the United
States. And so a new and stultifyingly
different business structure means that
profit margins – after the benefit of layoffs
and higher productivity are dissipated
– will be negatively affected by interest rate
increases. If so, the recovery will ultimately
flounder.
Another difference this time is that
individuals and companies are much more
in debt than they ever have been as seen
in the Chart below. Up to now with yields
declining and home mortgages, car loans,
and all sorts of debt being discounted to
���� ���� ���� ���� ���� ���� ���� ����
near 0% yields, the debt levels have not
mattered. Who cares, as the Chart shows,
that private sector debt as a percentage
of disposable income is now 25% higher
than it was at the beginning of the last
recovery? If you don’t pay any interest on
it, there’s no limit to the amount businesses
and consumers can borrow and therefore
spend. My point exactly: if and when rates
do go up, we will all care – the leverage
will work in reverse, the economy will
flounder.
Finally, it’s important to point out that
most U.S. corporations these days are
finance dominated companies whether
they make widgets or cars, whether they
sell insurance or overalls. Many if not
most American companies are profitable
primarily because of their finance
activities. Sears until just a few months
ago was really a credit card lender, not
a retailer. General Motors in this year’s
second quarter earned almost all of its
money from its mortgage subsidiary.
Deere sells tractors, but has a finance arm
that contributes a significant portion of
annual profits to the bottom line. Dare I
mention GE? It’s really more of a financial
conglomerate/leasing company. If it brings
good things to life, it’s because interest
rates are low and their profits are favorably
affected. Almost all of these companies
as well benefit by swapping their long-
term debt back into Libor-based/short-rate
sensitive hedges. If the Fed jacks yields,
they will pay through the nose and then
some, as will our economy.
One investment conclusion is this: do
not expect the Fed to be the hangman by
raising rates. If this were a game of Clue
and we were wondering whether the killer
was 1) Prof. Plum, 2) with a lead pipe,
3) in the library, you can be very confident
that it won’t be 1) Chairman Greenspan,
2) with an interest rate hike, 3) at the
Federal Reserve. He knows better and will
only raise short-term yields if and when
the U.S. economy appears to have the legs
to withstand such a shock. For all of the
above reasons, that day is far advanced
– way out there – back, back, back, back as
Vin Sculley might describe a Barry Bonds’
home run.
But there are other players in the financial
arena, including PIMCO, and they make
decisions too. Last month’s Outlook
suggested that Clue’s economic and bond
market murderer might ultimately be
1) Zhou Xiaochuan, 2) with a currency
reval, 3) in Beijing OR 1) Toshihiko Fukui,
2) with a Treasury bond sales ticket, 3) in
Tokyo. I described the near trillion dollars
of U.S. Treasury securities held by Asian
countries and posited that at some point
the risk might outweigh the reward and
that the ensuing sales might trigger a
run on the bank, a hike in yields, and a
beginning of the end for our Hummer
and Hummvee prosperity. Asia, and
principally China, might very well be the
prospective culprit – they have a pretty big
lead pipe that’s for sure and now it’s just
a question of motive, not opportunity. But
the fact is that for now, the status quo sort
of suits them. They are sucking up a lot
of Treasuries, yes, but they’re also putting
a lot of their people to work and in the
case of China, that means tens of millions.
Why revalue their currency, why sell their
surfeit of Treasuries if they can instead
employ the outflow of young workers from
exterior provinces into Shanghai by fixing
the Yuan to the dollar? In the case of Japan,
why risk renewed deflation via a stronger
Yen? Some say they should buy dollars,
buy Treasuries, do everything possible to
keep their exports competitive and their
economies above the line.
Last month’s Outlook suggested, however,
that sooner, perhaps later, they would act,
if only because the risk would become
unbearable, but the timing was unclear.
Just a week ago, though, the Yen cracked
the important 115 to the dollar barrier,
a sign that their appetite for dollars and
U.S. Treasuries might be sated, and that
the long enamored and widely held “Yen
carry trade” might be on its last legs. U.S.
Treasury yields have since risen.
Still, Asian countries’ apparent willingness
to trade-off jobs for a bad investment begs
a better question. If Asia is subsidizing
its growth by purchasing dollars and
Treasuries at a premium price, what
about all the rest of us? What ancillary
benefits do we get by purchasing a rich
dollar denominated bond? Surely PIMCO
and others get the same interest rate and
(absent money management alchemy)
we get the same return as do Asian
investors. We therefore are getting the
short straw, the hind teat, in short, a bad
deal. We have nothing to show for our
investment prowess other than an under-
yielding Treasury note denominated in
an overvalued currency. So when I wrote
last month that China holds the keys
to the Hummers, I was getting close to
identifying the culprit in our ongoing
game of Clue. What I didn’t suggest is
that the waiting game is a dangerous one
for other investors – they in fact could
be the victims. There are rewards for
playing of course. Instead of 3⁄4% money
market returns there’s 5%+ for holding
long Treasuries and even more if you
shift sectors to corporates and mortgages.
Rollers of the Clue dice rightly claim that
Prof. Plum or Japan central bank boss
Fukui might not be the one, or perhaps
that the dirty deed of reval or Treasury
sales might never happen. They have
a point. Waiting for Fukui or China’s
Zhou Xiaochuan could be an expensive
proposition. But what oh what if it turns
out to be true, or what if the PIMCOs
of the world wise up to their subsidizing
Chinese employment by holding an
overvalued Treasury portfolio? And, lest
I sound too apoplectic, the name of the
next game doesn’t have to be Armageddon.
A more likely course would posit reduced
Asian and U.S. purchases of Treasuries, a
diversification into Eurobonds, a stronger
Yen and Yuan over the next few years,
more expensive U.S. imports after a lag,
a sapping of consumer spending power,
gradually rising intermediate and long-
term rates, a declining housing market
and yes a near body blow to America’s
financed-based economy for all the reasons
outlined in previous pages. I reiterate: the
stocks, bonds, and currency of a debtor
nation in the process of reflating are not
attractive investments. At the moment the
markets are without one – but sooner or
later they are bound to get – a CLUE. My
vote, PIMCO’s vote, will be to play the
game with eyes wide open and our wallets
and purses close to the hip. Inflation and
currency protection will be paramount in
the initial stages of this game of Clue, and
credit protection in the latter phase as the
U.S. economy is mugged by a host of Prof.
Plum “act-alikes” with their lead pipes.
William H. Gross
Managing Director

Past performance is no guarantee of future results. This publication contains the current opinions of the author and does not
represent a recommendation of any particular security, strategy or investment product. Such opinions are subject to change without notice.
840 Newport Center Drive
This publication is distributed for educational purposes only and should not be considered as investment advice or an offer of any security
for sale. Information contained herein has been obtained from sources believed reliable, but not guaranteed. Newport Beach, CA 92660

Each sector of the bond market entails risk. Municipals may realize gains and may incur a tax liability from time to time. The guarantee on 949.720.6000
Treasuries and Government Bonds is to the timely repayment of principal and interest. Shares of a portfolio are not guaranteed. Mortgage-
backed securities and Corporate Bonds may be sensitive to interest rates. When interest rates rise the value of fixed income securities
generally declines. There is no assurance that private guarantors or insurers will meet their obligations. An investment in high-yield
securities generally involves greater risk to principal than an investment in higher-rated bonds. Investing in non-U.S. securities
may entail risk due to non-U.S. economic and political developments and may be enhanced when investing in emerging markets.
No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.
Pacific Investment Management Company LLC. ©2003 PIMCO. IO019-092303